By Ben Strubel of Strubel Investment Management, LLC
GameStop is the world’s largest retailer of video games and hardware. They operate 6,549 stores in United States, Austria, Australia, Canada, Denmark, Finland, France, Germany, Italy, Ireland, New Zealand, Norway, Portugal, Puerto Rico, Spain, Sweden, Switzerland, and the United Kingdom. GameStop’s profit comes from four product categories. Its new video game hardware category accounts for 6.5% of its gross profit; new video game software, 21.3%; used video game products, 46.8%; and other, 33.8%. Other includes video game magazines and various online video gaming properties.
GameStop’s core used game business seems to be under threat from a recent Federal Circuit Court decision and the announcement by BestBuy that they will enter the used game business. Meanwhile digital distribution is a looming threat for GameStop’s new games business. Morningstar recently summed up GameStop’s prospects this way: “We believe the long term prospects for this no-moat retailer are bleak.” It’s no wonder GameStop currently trades at a P/E of 8.79 and a forward P/E of 7.3.
So is GameStop a value investment or a value trap? Let’s look at the three main issues weighing on GameStop’s stock price: the Vernor vs. Autodesk court decision, used game competition, and digital distribution.
Vernor vs. Autodesk Court Decision
The Vernor vs. Autodesk court decision deals with the concept of “first sale,” which is described this way on the EFF’s website: “The ‘first sale’ doctrine expresses one of the most important limitations on the reach of copyright law. The idea, set out in Section 109 of the Copyright Act, is simple: once you’ve acquired a lawfully-made CD or book or DVD, you can lend, sell, or give it away without having to get permission from the copyright owner. In simpler terms, ‘you bought it, you own it’ (and because first sale also applies to gifts, ‘they gave it to you, you own it’ is also true).”
Recently, the Ninth Circuit court ruled in Vernor vs. Autodesk that an individual could not resell a piece of software produced by Autodesk on eBay because the court claimed the individual did not own it; they were just licensed to use it. The ramifications of this could be big: no more reselling of DVDs, CDs, or used video games. But before we panic, let’s look at the Ninth Circuit court and the decision itself.
First, the court’s decision was not “en banc.” That means it was not decided by the whole court, just a three-judge panel. While this is normal in most cases, for a case of this magnitude that overturns a previous ruling, it is odd that the decision wasn’t made en banc. Vernor has now filed a brief requesting a hearing en banc. This may lead to a modification of the original ruling.
Second, consider some background about the Ninth Circuit court. It is the most overturned circuit court in the country. Because of its zany decisions, it is sometimes referred to as the “Ninth Circus.” As of October 2010, of the 47 current federal cases the U.S. Supreme Court has agreed to review, 18 or 19 (if you count a special three-judge district court case) are cases from the Ninth Circuit. To put this in perspective, only 20% of the population lives in the Ninth Circuit district yet Ninth Circuit cases make up 40% of the nation’s reviewed cases. Cases from other federal circuit courts encompassing 80% of the population account for only 60% of the cases the U.S. Supreme Court will be hearing. The Ninth Circuit court clearly issues controversial rulings.
Furthermore, the Ninth Circuit court is the most overturned circuit court in the country. (There are thirteen circuit courts for those keeping track at home.) From October 2000 to October 2009, the Supreme Court vacated or reversed 148 of 182 of the Ninth Circuits cases. That is a reversal rate of slightly more than 81%. The other twelve circuit courts had reversal rates of only 70%. But, wait, it gets worse for the Ninth Circuit. Of the 148 cases the Ninth Court had reversed, 72 of those were unanimous reversals. That means not a single U.S. Supreme Court justice agreed with the original verdict. But, wait, it gets even worse. Of the 72 unanimous reversals, 15 were summary dispositions. (A summary disposition means the Supreme Court thought the original verdict was so erroneous that no briefs or arguments were needed for clarification or explanation.)
It’s easy to see how the Ninth Circuit court earned its circus nickname. Considering that the current Ninth Circuit ruling overturned a previous judgment in favor of Vernor, the fact that the current ruling goes against the long established “first sale” doctrine, and that the Ninth Circuit has an abysmal record on appeals; it is likely the decision will be modified or reversed. While legal experts might debate the validity of the ruling and debate the first sale doctrine’s application to software, the statistical evidence based on the previous record of the Ninth Circuit is in favor of a reversal or modification.
Used Game Competition
The used game business is the biggest source of GameStops’ profits and is a high margin business. It’s no surprise then that other companies have tried and are trying to muscle in on that business.
BestBuy and Wal-mart first entered the used game market in 2009 when they allowed a third party company, E-Play, to place used game kiosks in their stores. After just eight months of operations, in early 2010, E-Play shut down. But recently BestBuy announced it was reentering the used games business.
In the latest conference call, Paul Raines, the CEO of GameStop, said, “We have seen no competitive impact from emerging competitors in the used business and also have not seen any impact from the first user codes in recent titles. We are watching carefully the latest round of competitor entries in the used business, but would remind investors of the extensive competitive barriers GameStop has built around the used business.”
So what is GameStop’s competitive barrier? The network effect. Simply put, the network effect means a product or service becomes more valuable the more people use it. In GameStop’s case with its used business, the more people that trade used games in the more used game inventory GameStop has and the more used games GameStop has the more people want to go to GameStop to trade their games in and buy other used games. And so the cycle goes.
A competitive advantage such as the network effect is most durable when paired with some other advantage. Unfortunately, GameStop does not seem to have any other durable long-term advantages besides the network effect when it comes to its used game business. It is possible for competitors to overcome GameStop’s advantage by offering significantly better pricing on used games to entice more people to trade their games in, but the competitor will have to endure a period of low to no profitability while they attempt to steal market share from GameStop. As we saw with E-Play, the big box stores’ previous attempt only lasted eight months until they gave up. How long will a GameStop competitor